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Thursday, January 13, 2011

Where Did All the Money Go? Part Deux

Unrealized Profits never "evaporate" because they didn't exist in the first place!

On National People's Radio this morning was an advert for Ira Glass' This American Life. I like the show, as it has some interesting stories. I hate Ira Glass and the whole NPR "if you have a speech impediment, you've got a radio show!" theory. Like most NPR hosts, he is a little too smirky.

Anyway, the advert for his show (and all NPR is these days is adverts - for more NPR!) was about a story about the economic meltdown. Specifically, when the market crashed, where did all those trillions of dollars go? And the author of the story was shocked to discover that money was "fiction".

Sigh. Are people really that stupid? Apparently they are, or at least the new NPR thinks we are.

As I noted in an ear;ier post in response to Jame Surowiecki's equally as asinine comment about "disappearing money" there was no money to "disappear" and if you are having a hard time understanding this, I'll explain it really slowly, using simple words, and if you'd like, a large easy-to-read font.

Market Values Do Not Represent Real Money.

You see, if you buy something and it goes up in value, that does not mean you made money, until you sell that item. Similarly if you buy something, and it goes down in value, it does not mean you lost money until you sell that item.

So, for example, you buy a home for $250,000 and during the crazy decade it shoots up to $500,000 in value, you have not made any money, unless, like me, you cashed out at the height and SOLD the house. If the house drops down to $250,000 again, you have not "lost" any money, either.

The same is true with market valuations of stocks, which are horribly misleading. People like to say that ACME company has a market valuation of a billion dollars, because the stock is selling for $100 a share and there are 10 million shares outstanding (one thousand million equals a billion). The vaunted "market cap" of the company, calculated this way, makes the company seem to be worth a lot.

But most people didn't pay $100 a share for ACME stock. The founders, who own 1/3 of the company paid little - other than their sweat equity, initial small cash investments, and the risks they took borrowing $100,000 from the bank to start a company in their garage. Today, the founders are all millionaires - at least on paper - due to the "value" of their stock and the number of shares they own.

But if Joe Blow, President, CEO and founder of ACME, decides to cash out (and really become a millionaire) and sell a huge chunk of his stock, say, a million shares, the share price will drop. Why? Supply and demand, our old market bugaboos. Dump a million shares on the market, and the price drops as there is more being sold than there are buyers. And as a secondary effect, Joe has to report his "insider sale" of stock, which would surely worry analysts and drive the stock price lower.

So ACME stock drops in value to $50 a share. The company is now worth only $500,000,000. What happened to all that money? Again, it didn't exist. Don't confuse market values (what someone is willing to pay) with real value.

As an analogy, think of a car. You make money as a "dot com" entrepreneur and decide to buy a Ferrari. Problem is, every other "dot com" millionaire has the same idea, and even a hoary old Miami Vice type Testarossa is selling for twice was it was a few years back. You buy the car and drive it around and the "dot com" bubble bursts. So you decide to sell the Ferrari. But whoa! Ferrari prices have taken a tumble! You get only HALF back on the car. Where did all the money go?

Again, it is an asinine question. A car is not money, so there is no "money" going anywhere. You bought a commodity and the commodity dropped in value. And for most of us, that is exactly what happens with our cars - they depreciate over time. And yet, few of us ask "where did all the money go" when it comes time to trade-in our cars.

Market values are just evaluations by people of what they think something is worth, not its actual worth. And oftentimes, market values far exceed the actual worth of something, as market values are determined by supply and demand, not by inherent value.

So, if everyone wants to buy ACME corp. stock, because it is a sexy company with hot products and is getting good press, well the price shoots up - more people want to buy than sell. But if a product bombs in the marketplace, people want to sell, and prices plummet.

Or, if the overall economy stalls, and people need cash, they stop investing (lowering demand) and sell shares to pay bills (increasing supply) and prices plummet. There is no money "evaporating" - merely assigned values - psychological values at that.

Bear in mind that the Dow Jones Industrial Average is not a real number. It is made up by some people who calculate it based on the market price of a number of stocks - and that market price is determined by what some chump like you or me decided what to pay for the stock that day. Market prices are not determined by Wall Street Bankers or the folks at Dow Jones, but by you and me - the market.

And nowhere is this more true than with IPOs. The IPO people might like to say that GM stock is worth $35 a share, but the market eventually trades the shares at an equilibrium price - and this can be lower (as it was initially) or higher (as it is the day of this posting) without any money being created or evaporating.

Now, if you are a market fanatic, you say, "Well, that's OK, because Adam Smith taught us that markets always find the best price for a commodity, and if the market says it is worth X dollars, then it is worth X dollars!" And unfortunately, this "Mark-to-market" thinking is what sunk Enron - spending unrealized gains before they were made.

Market prices can be manipulated in a number of ways, many of them illegal. But one way market prices are manipulated is by our old friend supply and demand. The problem with supply and demand is that small variations in either factor can cause huge swings in pricing.

For example, suppose in a mythical town there are 100 houses for sale, for $100,000 each. 101 buyers set out on Sunday to go to open houses, each buyer willing and able and wanting to buy a house. Clearly, one buyer will go home with no signed contract for a house. But rather than sit home and say "Well, I guess I'll just have to rent," chances are, that 101st buyer will offer $101,000 for a house, and likely snag it from a lower bidder.

The problem is, that lower bidder may, in turn, bid up another house by another $1,000 or outbid the other fellow by another $1,000. The net effect is a price war. Since the increase in monthly mortgage payment for an additional $1,000 to $10,000 is pretty minimal, chances are, prices will escalate by at least $5,000 to $10,000 before finally one bidder says "You know what? That's too much money for a house in this jerkwater town! I'd rather rent!" and the market finds its equilibrium price.

But note how the housing price shot up 5-10% or more in response to a 1% offset in the buyer/seller balance. And also note how the process is reversible - if there are only 99 buyers in the marketplace, it is a buyer's market, and one home seller will end up holding on to a home he doesn't want - unless he lowers his price far enough to snag someone else's buyer - or persuade a non-buyer to become a buyer, and thus restore the buyer/seller equilibrium.

Small Changes in Supply and Demand Result in Huge Changes in Market Valuation.

So you see, when the economy stalled last year, the stock market tanked - by 50%. And a tanking market takes on its own momentum. Once buyers see that prices are falling, they stop buying. Why buy today when you can buy tomorrow at the same price - if not lower? And sellers start to panic and lower their prices further in an attempt to attract more buyers. It takes on a Calculus effect, with the second or third order differential of the price increasing dramatically. The vaunted "market price" is far from a fair evaluation of any commodity, stock, currency, or whatever, but can be subject to psychological pressures as well as huge swings in price based on small swings in supply and demand.

Smart investors, of course, can take advantage of these "panics" as they are aptly called, and sell early on, cashing out, and then buying back in at a far lower valuation. The hard part is to see when the market is over-valued, cash in at the right time, be able to hold on to cash for a long while and then buy back in at the nadir. Since few people can do this with any accuracy (except in hindsight) it is a difficult, if not impossible, game to play.

As I noted in my "The Greatest Invention - Money" posting, money is not a tangible or real thing - it is merely an idea. This is not to say it is a fiction as Ira Glass says, no more than a non-fiction book is a fiction in that it is just ideas on a page and not a tangible thing in real life. But as an idea it can be very flexible and malleable. And market values are even worse, as they represent other people's ideas about what something is worth. And as we all know, most people are idiots.

So where did all the money go? Short answer: It never existed. When you buy stocks, you are not buying money - you are buying a part of a company. And like any other commodity, it can increase or decrease in value over time - just as your house, a collector car, a rare painting, or any other tangible object can increase or decrease in value over time.

So yes, while you may have "lost money" on a stock, you also "lost money" when you traded in your used car - its market valuation decreases over time. If you buy high and sell low, you create a realization event with a negative outcome. For those of us who didn't sell in February 2009, well, the market has largely recovered and our portfolios are about the same as they were at the market peak.

But "Trillions of dollars" didn't "evaporate overnight" as the commentators like to say. Market valuations just changed - and that happens all the time in markets for various commodities.

And that is why, when investing in stocks, you should realize that you can lose it all potentially, particularly if you invest only in one stock and that company goes bankrupt. And this illustrates why having a diverse portfolio is so important - having "real" money in terms of cash, deposits, bonds, and other assets that are, basically the equivalent of cash.

And it illustrates why getting out of debt and staying out debt is so important. Investing money in the stock market while accumulating debts is a bad idea - your investments can go South in a real hurry, but debts stay the same, if not increase. And yet many people pooh-pooh the idea of paying down debt, claiming that the "opportunity cost" is too high - and that they can get a better return in the stock market than they can get in paying off their mortgage.

Perhaps so, but then again, perhaps not. And if not, bad things snowball in a hurry. Paying down debt, paying off debt is one "investment" that does have a guaranteed rate of return. Why? Because unlike stocks and other commodities, debt is real money, and a dollar paid down is a dollar paid off - for good!